The Canadian bond market experienced a see-saw month in September. Initially bond prices fell and yields rose as investors anticipated a possible rate increase later in the month by the U.S. Federal Reserve, as well as speculation that the Bank of Japan would adjust its monetary stimulus to steepen its yield curve. The bond selloff was exacerbated by the European Central Bank’s decision to not increase its stimulus programme. Around mid-month, the market pessimism faded and bond prices began recovering as investors realized that persistently slow global growth would prevent most central banks from removing monetary stimulus. A stand-pat decision by the Fed at its September meeting reinforced this view. In addition, regulatory problems for two major commercial banks, Deutsche Bank and Wells Fargo, created a flight-to-safety bid for bonds that pushed prices higher and yields lower. Late in the month, a tentative deal between OPEC and Russia to limit oil production sparked a jump in risky assets that reduced demand for bonds. The FTSE TMX Canada Bond Universe returned 0.25% in September.

Canadian economic news was somewhat disappointing early in the month, but finished stronger. On balance, the data showed Canadian economic growth to be well below potential, but still positive. Unemployment rose to 7.0% from 6.9% the previous month, but the details were encouraging. The higher rate reflected an increase in the participation rate, as job creation was robust and there was a shift to full time positions from part time jobs. Unfortunately, the better labour market conditions failed to impact consumption as retail sales were weaker than expected.  Late in the month, the July GDP data was released and showed a continued rebound from the impact of the Alberta wildfires in May. The data also showed that over the last twelve months, the Canadian economy grew a tepid 1.3%. As was widely expected, the Bank of Canada left its administered rates unchanged.

In the United States, the key event was the U.S. Federal Reserve interest rate announcement on September 21st. In the weeks leading up to the Fed’s meeting a number of officials had suggested an interest rate increase was possible so, as the meeting approached, investors grew increasingly nervous and bond prices fell and yields moved higher. In the end, the Fed stated that the case for higher rates had strengthened but it chose to leave rates unchanged for the time being. Importantly, three members of the committee dissented, wanting an immediate increase in rates. U.S. economic data received during September was positive, on balance, but failed to provide the Fed with an impetus to adjust policy.

With little in the way of economic surprises, the Canadian yield curve took its lead from international sources, particularly the U.S. yield curve. The Canadian curve steepened modestly as 2-year bond yields declined 6 basis points while 30-year yields rose 4 basis points. The changes were quite similar to the shift in the U.S. bond market as no immediate rate increase allowed shorter term yields to ease slightly, while longer term yields focussed on the increased likelihood of a rate hike in December.

Higher long term yields offset the benefit from lower short term bond yields and, as a result, the federal sector returned only 0.10% in September. The provincial sector earned 0.30% in the month, as yield spreads narrowed an average of one basis point. The largest spread narrowing occurred with long term provincial bonds, which helped neutralize the impact of their longer average duration. The investment grade corporate sector returned 0.37% in the period, with yield spreads narrowing 2 basis points on average. The BBB subsector was the strongest performing one in September as merger and acquisition activity amongst pipeline companies helped strengthen creditworthiness. BBB-rated issues returned an average 0.56% compared to A-rated issues that earned only 0.26%. There were $7.2 billion of new issues in September, with the vast majority occurring in the first half of the month. The risk-off attitude of investors in the second half discouraged issuers and the deals that did come to market in the period did not trade well in the after-market. Non-investment grade bonds returned 1.16% in September as investors continued to pay up for yield, notwithstanding credit risks. A new 7-year issue of Air Canada demonstrated the lack of concern for credit risk. Notwithstanding that the company has twice sought CCAA protection from its creditors and a B+ rating from S&P, Air Canada was able to raise $200 million at only 4.75%, well below our view of fair value. Real Return Bonds earned 0.18% in the month and the S&P/TSX Preferred Share Index declined 0.10%.

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